Friday, 27 September 2019

Some Ideas on Managing Portfolios

Portfolio management is more than the sum of the purchase of attractive stocks.

Here is a view on the overall lines of action on managing portfolio:

  • The first step (optional) involves trying to acquire some idea about where we are in the cycle.
  • Diversification
  • Stock selection should be bottom-up.
  • Pay particular attention to the weight of stocks in the portfolio.
  • Changing weights.
  • Sectoral efforts.

1. Where are we in the cycle? (Optional)

This involves trying to acquire some idea about where we are in the cycle.

Should we be moving towards defensive stocks, or - on the contrary - starting to be more aggressive, if we judge the declines to have been sufficient?

It is helpful to analyse the message coming from the types of stocks that interest us, so as to draw the right conclusions about what is going on. If some stocks in a sector have taken a particular hammering, it is likely we will be at the bottom of the cycle in that sector.

Overall market developments will also give us some insights. If there have been lots of very strong rises, we will be heading towards the end of a cyclical expansion, while after a series of large losses, we will doubtless be close to the bottom.

However, there is no guarantee that our analysis of the cycle will be successful.

If we are able to have some degree of clarity on the overall or sectoral cycle, then the next step is to consider which types of stocks will us in this context.

We need to buy the most aggressive stocks during low points in the cycle, even if it can be challenging to overcome the mental barriers to do so in such a negative environment. And vice-versa at the top of the cycle.

Designing the appropriate strategy for the general or sector cycle can be what adds most value to a portfolio.

2 Diversification

Our portfolio should be prepared to withstand any situation, be it a market collapse or a boom, inflation or deflation, for all possibilities. It must be agile and resilient against any eventuality.

We also have to insulate the portfolio from our own errors, whether they be our view of the cycle or our choice of companies. We have to envisage how our portfolio would be affected by the opposite scenario to what we are expecting; how it would survive.

Diversification is the clearest way to prepare the portfolio for any eventuality. Having at least 10 stocks gives us a reasonable amount of diversification. If we are managing on behalf o others, it can be helpful to hold a few more, creating a portfolio of some 20 - 30 stocks. After that, there need to be strong arguments for increasing the number of stocks.

3. Stock selection should be bottom-up.

Stock selection is the first step in managing portfolios. Avoid wasting time on companies which do not stand up to greater scrutiny. It is also important to be very flexible: avoiding slipping into generic asset allocation, both for sectors and regions. If we don't understand a certain business or new technologies, it is best to avoid them.

4. Pay particular attention to the weight of stocks in the portfolio.

Over the years, we got it wrong on a number of stocks. We must be very sure of our investment if we are going to assign it a high weight in our fund, never doing so if the company is indebted.

It is extremely difficult to discern and accept investment errors: we always end up giving the benefit of the doubt to the company, since after investing so much time studying it, we find it deeply unsatisfying to sell and think that we are throwing it away. One of the ways to get around this problem is by only having small exposures to the more dubious stocks.

5. Changing weights.

One of the ways to add value in asset management is by changing the size of positions in stocks. The argument for continually adjusting is one of simple probabilities: if a stock in a portfolio rises by 10% and another falls by 10%, then there has been a relative movement of 20% which we can capitalize on. The logical thing to do, once we have studied the movements, is to lower our position in the stock that has gained value and increase it in the one that has fallen.

Some investors prefer to wait until the stock has reached the target price before offloading the entire position, or take other approaches. However, it is highly likely that our simple approach increases the potential of the fund, since it is unlikely the valuations of the particular shares have moved in the same proportion.

6. Sectoral effort.

We should focus on attractive sectors. it is impossible to be on top of every sector. As unspecialised generalists we should discriminate between sectors that are worth following - which form the focus of our efforts - while leaving the rest to one side. Not all sectors are equally attractive all the time, and it take years for the level of interest to shift.

We should devote the bulk of our resources, especially time, to the most attractive sectors. We should keep an eye on other sectors, being aware of their existence, but they should not eat up our time for the moment. By moving from less attractive to more attractive sectors we avoid wasting time, which is an extremely scarce resource in investment analysis. There will be time in the future to return to sectors left to one side.

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